Home > The Impact of Non-Transparency on Foreign Direct Investment
Staff Working Paper
ERAD-99-02 Revised November 2001
World Trade Organization
Economic Research and Analysis Division
The Impact of Transparency on
Foreign Direct Investment
1
Zdenek Drabek: WTO
Warren Payne: Economic Consulting Services, Inc.
Washington, D.C.
Manuscript date: August, 1999
Revised November 2001
Disclaimer:
This is a working paper, and hence it represents research in progress.
This paper represents the opinions of individual staff members or visiting
scholars, and is the product of professional research. It is not
meant to represent the position or opinions of the WTO or its Members,
nor the official position of any staff members. Any errors are
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and title.
The Impact of Transparency on
Foreign Direct
Investment
Zdenek Drabek* and Warren Payne
World Trade Organization Economic Consulting Services, Inc.
Geneva
Washington, D.C.
*Views expressed in this paper are personal and should in no way be interpreted as official or representing the position of the World Trade Organization or its Member Countries. We are grateful, without implicating, Marion Jansen, Roberta Piermartini and two anonymous referees for helpful comments on the previous draft of the paper
ABSTRACT
Non-transparency
is a term given in this paper to a set of government policies that increase
the risk and uncertainty faced by economic actors foreign investors.
This increase in risk and uncertainty stems from the presence of bribery
and corruption, unstable economic policies, weak and poorly enforced
property rights, and inefficient government institutions. Our
empirical analysis shows that the degree of non-transparency is an important
factor in a country's attractiveness to foreign investors. High
levels of non-transparency can greatly retard the amount of foreign
investment that a country might otherwise expect. The simulation
exercise presented in the statistical part of this paper reveals that
on average a country could expect 40 percent increase in FDI from a
one point increase in their transparency ranking. Pari passu,
non-transparent policies translate into lower levels of FDI and hence
lower levels of welfare and efficiency in the host country's economy.
A nation that takes steps to increase the degree of transparency in
its policies and institutions could expect significant increases in
the level of foreign investment into their country. This increased
investment translates into more resources, which in turn increases social
welfare and economic efficiency.
Key Words:
Foreign direct investment, transparency, corruption, FDI modeling.
JEL Classification No. [F02] [F13] [F21] [F23] [M14]
1. Introduction
The issue of
transparency in economic and business decisions has become one of the
most talked about and novel topics in economics and finance and among
businessmen and policy makers. Surely, economists and businessmen as
well as government officials have always been aware that access
to information may be impeded or costly or that business practices can
differ from country to country - for better or worse. Nevertheless,
it is only in recent years that transparency has become a major issue.
The lack of transparency has been used by some observers as an argument
towards redirecting foreign aid among countries. For example, in their
study of foreign aid flows, Alesina and Weder (1999) show that foreign
aid is not necessarily offered to the least corrupt governments. They
further argue that donors should rethink their aid policies if they
are truly serious about encouraging "good governance".
The lack of
transparency has been also tied to the financial turmoil first witnessed
in Mexico and later in Asia and other parts of the world. Following
these financial crises, it is now widely recognized that the availability
of timely and complete information is crucial in order to avoid the
kinds of violent instability of financial markets that we have witnessed
in recent years. It is no surprise, therefore, that M. Camdessus, the
Managing Director of the IMF, thinks of transparency as the "golden
rule" of the new international financial system.1
Transparency has been proposed for the agenda of
multilateral negotiations such as those in the OECD, and pursued as
a powerful objective of influential non-governmental organizations
such as Transparency International. Transparency in economic policy-making
now also figures as an important condition for lending by international
financial institutions. In sum, "transparency" has become
the "buzz-word" of modern politics and economics.
In this paper
we shall address one issue that has so far not received much attention
in the discussion – the impact of transparency (or, rather, the lack
of it) on flows of foreign direct investment (FDI). As we shall
argue further below, there are strong reasons to believe that transparency
in economic policy-making and in the activities of government institutions
is vital in attracting foreign investment. If so, one would expect that
countries with more transparent trade and investment regimes will attract
more FDI than those that are plagued by the perception of bureaucratic
inefficiencies and the existence of corruption and other related problems.
The main purpose
of this paper is to evaluate the effects of transparent policy regimes
on FDI inflows. In order to do so, we have developed a simple econometric
model which we have tested with the help of standard statistical methods.
The tests confirm our hypothesis that more transparent policy
regimes indeed act as a strong incentive for foreign investors and
vice versa.
The term "transparency"
may be even currently somewhat "overused". It is often
put forward out of context or without a specific meaning. This makes
discussions about transparency too general and limits the scope
for policy recommendations. We shall try to avoid committing the same
error. Before plunging into the empirical analysis, we shall, therefore,
examine the concept of transparency in more abstract terms.
We shall first discuss various aspects of transparency as they are related
to economic policy-making. In addition, we shall examine the reasons
why transparency of policy regime is particularly important for foreign
investors.
Why do we focus
on FDI? The answer is very simple – FDI has become an increasingly
more important factor of economic growth. This is reflected in the trend
over the last several years as countries have increased reliance on
FDI. Between 1986-1989 and in 1995 the rate of FDI grew more rapidly
then world trade in goods. Between 1973 and 1995 the value of
FDI multiplied by more than 12 times, from $25 billion to $315 billion,
while the value of commodity exports multiplied by about eight and a
half times, from $575 billion to $4900 billion.2
In many cases the value of FDI flowing into a country exceeds the level
of official government aid to that country.3 In brief, while the value of
international trade in goods is still far greater than the value of
FDI, FDI plays an increasingly important role.
Developing
and transition nations have a particularly strong interest in
attracting foreign capital. Domestic savings are often insufficient
in these countries to finance their investment needs. This capital
shortage affects both public and private investment. The Asian
Development Bank predicts that the demand for infrastructure investment
in Asia alone will reach $150 billion annually by 2010.4
The World Bank forecasts the need for investment between $1.2 and $1.5
trillion in infrastructure development in developing East Asian countries.5
Foreign investment is also a key component of privatization schemes
in transition economies in Central and Eastern Europe. The privatization
process in the Czech Republic, Hungary, Poland as well as in countries
like Slovakia, Bulgaria, and Romania, has actively pursued foreign
capital.6
We shall organize
the paper into 7 sections. The following section 2 introduces
the topic by defining the range of issues which represent the
origins of non-transparent economic policies. In the same section we
shall also review the broad effects of non-transparent policies. In
section 3 we shall asses the importance of transparency specifically
for FDI. Measures to improve transparency will be discussed
ion section 4. Section 5 represent the empirical part of this paper.
It includes a discussion of methodology and provides a summary of the
empirical findings, with more detail provided in the statistical appendix.
Policy implications of our findings are discussed in section 6 and conclusions
are presented in section 7.
2. Scope and Origins on Non–Transparent
Economic Policies.
The term transparency
of economic policy is a catchall phrase that refers to the clarity
and effectiveness of activities with impact on public policy.
In the economic literature, the discussion about transparency has been
mostly focussed on two key topics – corruption and bribery and
on protection of property rights, but the issue is much larger
as we shall now argue. Moreover, the literature has mainly been concerned
with the activities of governments and their institutions. Even though
we shall limit our empirical part of the paper to the same agent, this
too is an oversimplification.
Let us start
by considering the question of transparency in economic policy-making
of governments. The lack of transparency has for us five different origins.
First, economic policy – making will be seen as non-transparent if
it is subject to corruption and bribery . By definition,
bribery involves illicit payments which are never "advertised",
or made otherwise public even though corruption may be sometimes so
widespread that "everyone knows". Bribery is non-transparent
not only because it is normally illegal but also because the non-transparency
strengthens bargaining positions of the beneficiaries from these illicit
payments. The impact of bribery can be economically highly distortionary.
For example, in his work on the effect of corruption on government
activities Tanzi shows that corruption distorts public investment
(Tanzi et al.1997 and Tanzi 1999). Similar point is made by Mauro
(1995) and (1996) who investigates the impact of corruption on
various government expenditures and on public and private investment
respectively. Corruption can also have highly detrimental effects
on the country's distribution of income and worsens poverty (Gupta
1998) . Corruption and bribery have been also found to have an adverse
impact on capital accumulation and may even threaten stabilization
programs supported by the IMF (Asilis et al.1994). Further evidence
of serious distortions has been provided in numerous World Bank studies
such as those of D. Kaufman et al. (1999) as well as by other
researchers.
The second
important element of non-transparency arises in the area of property
rights and their protection within a given country . The lack of
copy right protection, the existence of patent infringement and lack
of enforcement of contracts are all examples of what constitutes poor
protection of property rights. The protection of property rights is
vital for firms to pursue new investment and research in order to ensure
that firms will see return from their investments7.
Without this profit incentive there is little motivation to take risks
and invest. In addition, weak property rights result in the distribution
of assets as common property, and as is well known, common property
situations may result in sub-optimal allocation of assets.8
This could be a particularly serious problem for countries that are
undergoing fundamental changes of their institutions and, in general,
for developing countries. The questions of property rights have been
examined extensively in the literature including issues related
to investment behavior of firms. Developing countries are particularly
susceptible problems related to the protection of intellectual property
rights. For example, a recent study of National Economic Research
Associates shows that developing countries benefit a great deal from
instituting a stronger protection of intellectual property rights. 9
A study of Weimer (1997) also makes essentially the same point when
it argues that political systems can have significant impact on the
credibility of commitments on property rights, with a special
focus on post-communist nations.
The third and
fourth aspects of non-transparency relate to the level of bureaucratic
inefficiency within the government and poor enforcement
of the rule of law. These two factors can pose severe barriers
to business. If the quality of government service is unpredictable,
companies' exposure to additional risks is increased. Moreover,
their ability to cover against these risk impeded due to the unpredictable
nature of government service. OECD (1997b), for example,
shows that bureaucratic inefficiency and weak rule of law impede economic
activities by imposing additional costs on economic agents. Delays
in licensing, the inability of the courts to enforce contracts
and the capricious and arbitrary enforcement of rules and regulations
all reduce economic efficiency and effectiveness.10
Finally, the
fifth origin of non-transparent economic policies has a great deal to
do with the conduct of economic policies per se. Economic policies
are likely to be treated as non-transparent if they are subject
to unpredictable policy reversals. These policy reversal
are particularly damaging in privatization deals and whenever
foreign investors are involved. Consider, for example, the case of privatization
in country X in which the government summarily cancels decisions
of the previous government to privatize the country's industry. The
reaction of foreign investors to the policy reversal is likely to put
the country concerned "off-limits" for foreign investors.
Unfortunately, this is not a hypothetical case as we have seen in recent
years in a number of countries which range across different regions
and cultures such as Indonesia, Nigeria or Slovakia. In each one of
these countries, the lack of transparent policies has been suggested
to be one of the main reasons why foreign investors have demonstrated
extreme caution to invest and for capital flight. This reflected
a growing suspicion of investors about the intentions of governments
concerned and their commitments to policies in the countries concerned.
Related example
on non-transparent economic policies is one in which economic decisions
are perceived to be arbitrary. Absence or poorly executed tenders for
sales of assets is a relevant case in point. It is clear that for tenders
to be perceived to be transparent they must be based on rules, and these
rules must not be ambiguous and, once accepted, they must not be changed
except in exceptional circumstances. Moreover, if exceptions are to
be permitted these must be well understood and known to all participants
in advance.
Who is guilty?
But the issue of transparency is, of course, much wider. Bribery and
corruption, for example, are not necessarily the "privilege"
of governments only but they have "infected" even private
businesses in some countries. Moreover, lack of transparency
has been criticized in the case of institutions that play an important
role in the provision of public information - and thus in the conduct
of public policy – and they are not government institutions. Take
the case of rating agencies that provide credit ratings of
governments, private businesses and other institutions. These agencies
play a crucial part in influencing investors' decisions with their
credit assessments even though, as some would argue, they are not subject
to the strict scrutiny of markets or regulators. In recent discussions
of the Basle banking criteria, Financial Times
complained that " markets and regulators should keep a closer
eye on the record of rating agencies and demand greater transparency
from them". 11
International
organizations have also recently become targets of public criticism.
Following the "Mexico crisis", the International Monetary
Fund has been under attack by their critics about its practices of
keeping certain information out of the public domain or not providing
information faster to the public.12. As a result of this criticism, the
IMF has been revising its policies concerning the release of economic
and financial information on individual countries in order to make its
own practices and countries' economic conditions more transparent. The
pressure is also on other economic and financial multilateral institutions.
For example, a recent meeting of a committee on technical barriers to
trade of the World Trade Organization has suggested that " information
regarding current work programs and proposals (on international
standards) … should be made easily accessible and comprehensible to
all interested and related parties".13
It must be
also recognized that the question of transparency can go even beyond
individual economic agents – such as firms, governments, public policy
institutions or even individual governments. Take, for example, the
case of the ongoing discussions about international
financial "architecture". One of the recent proposals was
to ensure that the International Monetary Fund should be in the position
"to give moral and financial support to countries imposing capital
controls or suspending debt repayments".14
The idea is not to help countries in distress but also "to guide
expectations by providing a transparent and timely explanation of why
a particular approach to a private sector involvement was taken"15.
Clearly, for this proposal to be workable, this can only be if it is
agreed by the major shareholders of the IMF. This cannot be a proposal
of a single government but it must be the outcome of international cooperation.
The fact that the proposal was indeed made by the finance ministers
of the Group of Seven countries gives it a far better chance of acceptability.
In brief, the
concept of transparent economic policy-making is very broad and needs
to be considered in its entirety if economic policies are to
be seen as truly transparent. Nevertheless, our own treatment
of the subject will have to be narrower. We shall only consider those
aspects of transparency that relate to government policies and
of activities carried out by government institutions. The reason
is a matter of expediency rather than of theory. Our choice has been
to some extent determined by the constraints of our empirical tests
which in turn have been influenced by the availability of data.
In addition,
for many reasons governments tend to be most implicated as the origin
of corruption and in the lack of transparency Economic policies
and activities of government institutions can be perceived as
transparent if the actual policies reflect their actual design
in that they transmit the intended messages and signals. Similarly,
economic institutions can be treated as transparent if their activities
exactly conform to the stated objectives of these institutions
and they carry out activities fully consistent with these
objectives. Moreover, for economic policies and government institutions
to be transparent it must be, of course, assumed that economic policies
are clearly formulated, and that government institutions do have
clear objectives and mandates. In brief, governments affect
transparency through activities that they themselves control – regulatory
activities, public sector policies and other. Thus, our focus on governments
is given partly by technical reasons and partly by the important role
of governments as an economic agent.
3. Why is
Transparency Important for FDI?
Transparent
economic policies are vital for foreign investors, and the reasons are
several. The first reason is that non-transparency imposes
additional costs on businesses. These additional costs arise
as firms have to tackle the lack of information that should have
been provided by the appropriate government department in the implementation
of its policies and in the activities of government institutions.
For example, firms bidding for a state asset expect to receive full
information from the government about the company to be privatized.
Any set of information that falls short of the expectation of the bidders
will have to be supplemented – at extra costs, and the latter
are typically incurred by the bidders.
Additional
costs are also incurred because of corruption - another element of non-transparency
identified above. In many countries, bribery is illegal.16
Bribery raises, therefore, the risks and the costs of non-compliance,
and the companies will only take the risk if the rewards are sufficiently
high. Corruption can indeed be very costly to firms. By way of example,
bribes are estimated to have accounted for 7 percent of revenue of firms
in Albania and Latvia in mid-1990's and in Georgia the corresponding
figures was even higher – 15 percent.17 This process would lead to an investment
selection that often has little to do with choices based on bona
fide project appraisal but rather to projects selected on the basis
of contacts, pressures, rent-seeking alliances etc. Moreover, the majority
of law-abiding companies will typically avoid doing business in countries
in which bribery is an inseparable part of business. In brief,
the existence of strong legal provisions against bribery and their effective
enforcement will go a long way towards inducing FDI flows.
The second
reason why transparent economic policies are important for FDI
is because they facilitate cross- border mergers and acquisitions.
When firms decide to acquire companies abroad, they will often have
to have their acquisitions approved by the Monopoly Commission
or its equivalent in the host (i.e. foreign investment receiving)
country. However, the practices of these competition commission
often vary from country to country and from region to region. For example,
Neven, Papandroupulos and Seabright (1998) argue in their study of the
European competition policy that the Competition Commission of the European
Union enjoys high level of discretion with very little transparency.
It is perhaps, therefore, not surprising that we have so far witnessed
little of cross-border mergers and acquisitions within the European
Union.
The third reason
is closely related to the previous discussion of competition policies.
Foreign investors require transparent protection of property rights.
As we have argued above, investors generally require that their
property be protected and that the protection be transparent.
What holds for investors in general holds, of course, it holds for foreign
investors in particular. This conclusion is intuitive but it also
has a strong backing from business attitude surveys and from empirical
literature such as the study of Rapp et al.. (1990) who find
that effective protection of intellectual property rights is strongly
correlated with inflows of foreign investment.
The fourth
argument for transparent economic policies is that they positively influence
business attitudes. Virtually all surveys of business attitudes
convincingly show that companies base their decisions to invest abroad
on their perceptions of what economists like to call "fundamentals".18
The latter include macroeconomic conditions such as low and predictable
inflation, prospects of fast economic growth, healthy balance-of-payments
position. They will typically also include factors such plentiful and
relatively skilled labor force, access to natural resources, efficient
infrastructure etc. Furthermore, and most importantly in the context
of our paper, investors typically seek clear, open and predictable economic
policies that minimize the risks of unpleasant and costly surprises.
Open trade and investment regimes are particularly powerful instruments
to attract investments in general and foreign investments in particular19.
Clearly, transparency of economic policies and government institutions
figures prominently on the minds of businessmen and in the meetings
of corporate boards of multinational companies.
The absence
of comprehensive and symmetrical legal provisions concerning business
practices has a number of effects for companies. One of the most serious
effects is arguably their impact on the competitive position of
firms which may differ among countries as a result of these differences.
For example, US Federal law prohibits U.S. firms from using bribery
to gain access to foreign markets. By contrast some European countries
allow firms to treat bribes paid as deductions in calculating
their tax liabilities. This asymmetry of rules poses a disadvantage
for U.S. firms. Therefore, the elimination of corruption is an important
issue for U.S. firms as a means to level the playing field.
Finally,
there is another, and perhaps the most important reason why economic
policies must be transparent if countries can establish favorable conditions
for capital inflows. The reason is countries' policy performance and
transparency are monitored by outside agencies which have a crucial
impact on decisions of foreign investors. These agencies include the
IMF and various private credit rating agencies. Their influence is different
– the IMF provides a "credit of approval" of sound
economic policies while credit rating agencies evaluate the credit risk
of the country concerned. Their similarity rests on the fact adverse
judgement on government policies in a given country will typically lead
adverse perceptions by foreign investors of that country. As frivolous
as it might sound it is a well known fact from the business community
that foreign investors would base their investment decisions on credit
assessments and country rankings established by some credit rating agencies.
The fact that we shall also heavily rely on country rankings in our
empirical part further below is not, therefore, an entirely academic
exercise but one that is strongly derived from the reality.
4.
Measures to Improve Transparency and the Role of WTO
Given the diversity
of non-transparency elements, the measures required to address the specific
issues will vary from case to case. For example, bribery and corruption
will require quite different measures than those problems that are related
to bureaucratic inefficiencies or protection of property rights. Each
case of non-transparency would, therefore, have to be discussed separately.
We do not propose to discuss these measures in any detail but thought
it important to raise those issue that will require priority attention
of policy makers in the future.
Elimination
of corruption and bribery will sometimes call for relatively straightforward
and simple solutions such as a reduction of government interventions
in markets. On the one hand, this could include, for example, the elimination
of price controls, reduction of regulatory activities of governments
to only those activities that are absolutely necessary, elimination
or a reduction of licensing schemes etc. On the other hand, this may
also call for measures that are far more complex. These may include
measures to change business and bureaucratic attitudes; for example,
corruption in some countries may be so culturally engrained that it
may be regarded as socially acceptable. Clearly, elimination of
corruption will have to be handled with care and sensitivity and will
require much more than an act of legislation.
Protection
of property rights can be also increased in a variety of ways.
Protection of intellectual property rights can be improved by the adoption
of the appropriate legislation in countries in which such a legislation
is still lacking. The legislation should be consistent with the
internationally accepted standards and conventions. Otherwise, countries
which export products and services that are subject to intellectual
property rights will be reluctant to make these products available abroad.
Pari passu, foreign investors must also be protected against nationalization
and other forms of expropriations – the most blatant forms of
violation of property rights. Last but not least, commercial contracts
must be backed up by enforceable laws.
Administrative
inefficiency is probably today the most frequently observed deterrent
to FDI. Discretion rather than a system based on rules,
"red tape", lack of skilled personnel, poor public pay policy,
overstaffing, these all just some examples of the origins of administrative
inefficiencies. Many of these problems can be overcome by the adoption
of measures and systems that increase transparency and reduce arbitrariness
of government decisions. An important road to take is to adopt a system
based on well designed tenders for government procurements and public
investments, public offerings and other competitive measures for
privatization of state assets, solid pay for public officials
or other measures as the specific cases may call for.
The next important
question is whether the measures should be confined to national legislation
or whether countries should be encouraged to enter into international
obligations. Probably both will be necessary. Domestic legislation
is obviously crucial and must provide the basis for all activities
of firms and governments. However, an agreement on international
investment has been gaining support among the proponents of free trade.
A common belief is that a multilateral agreement on investment will
generate an increase in FDI for the member nations. This is, of course,
only a necessary but not a sufficient condition but what the agreement
will do is to provide a framework of transparent conditions to
facilitate the movement of capital. This argument is based on two simple
ideas. First, a foreign investment law such as an international agreement
will make countries' legal framework much more transparent than foreign-investment
related domestic pieces of legislation. Second, international commitments
and laws are in many countries above the national laws – phenomenon
frequently observed in relatively less developed countries.20
Even though the push for negotiating a multilateral agreement continues
to be resisted21, the merits of such an agreement
in terms transparency are now increasingly well understood.
A multilateral
approach also means greater trade and investment openness which
in turn means less corruption. In their study of trade and investment
regimes, Selowsky and Martin (1997) found that trade and investment
openness have a positive impact on the reduction of corruption.
The open trade and investment regimes are conducive to FDI inflows for
different reasons. Clearly, the presence of international agreements
– multilateral and regional agreements on trade as well as regional
agreements on foreign investments - has been a major factor. Moreover,
open trade and investment regimes, supported by such agreements, can
have a significant impact on the size, structure and the performance
of government sector, which can facilitate the expansion of trade
and investment. For example, Rodrik (1998) finds that an economy's
exposure to international trade is positively correlated with
the size of its government – a phenomenon that he explains
on the grounds of useful roles performed by governments in supporting
international trade activities of the private sector. Brunnetti and
Weder (1999) argue in their recent paper that openness also leads
to other positive political and economic effects that are relevant for
the transparency of government activities – better basic government
services such as well–enforced rule of law, security of property rights
and reliable bureaucracies.22 By definition, trade liberalization
increases competition in domestic markets which, in turn, puts
pressure on domestic firms as well as government to increase the quality
of their services. Increased market penetrations by importers and foreign
investors means that they demand better services, more information and
, in general, a level playing field.23
The step towards
a multilateral agreement on investment would be relatively short. The
reason is that foreign investment is already subject to a number of
WTO agreements and WTO-related rules.24 These include General Agreement
on Trade and Services (GATS) which recognizes that the supply
of many services to a market is difficult or impossible without the
physical presence of the service supplier. Thus, the agreement
allows commercial presence of one member in the territory of any
other Member country. Foreign investors are also protected through
the Agreement on Trade-Related Aspects of Intellectual Property Rights
(TRIPS) whereby each WTO member accords in its territory protection
of intellectual property rights of nationals of other WTO countries.
Third is the Agreement on Trade- Related Investment Measures (TRIMS)
which identifies investment measures that are inconsistent with the
GATT – essentially local content and trade balancing requirements.25
Fourth is the Agreement on Subsidies and Countervailing measures that
defines the concept of "subsidy" and establishes the disciplines
on the provision of subsidies. Fifth is the Plurilateral Agreement on
Government Procurement that states that there be no discrimination not
only against foreign products but also against foreign suppliers including
domestic suppliers of foreign affiliates. Finally, foreign investors
are affected by provisions of the Uruguay Round Agreement on Dispute
Settlements.
Would the multilateral approach reduce corruption? What we argue in this paper is that a multilateral agreement on investment is likely to lead to a further reduction in trade and investment barriers. This, in turn, will be conducive to more transparency and less corruption. We are not suggesting that the agreement would have to specifically target corruption as one of its objectives. This may or may not be the case. What we are only suggesting at this stage is that less corruption would most likely be a by-product of a transparent multilateral agreement on foreign investment.
It is not clear
at present time which way the pendulum will eventually move. Nevertheless,
the pressure for an international agreement that would address the transparency
issue is growing even among the governments. By way of one example,
a recent meeting of APEC on the New Millenium Round has advanced a new
initiative "…. to strengthen the functioning of markets"
and concluded with a proposal for a framework that focus on such
areas as greater transparency (e.g. transparency in government
procurement), improved corporate governance and electronic commerce."26
In this context, it seem evident that the discussion about the
usefulness of a MAI would be enhanced and negotiations about a future
MAI moved forward if we had a better feel about the extent
to which the lack of transparent regime towards FDI impede the flows
of FDI into host countries. To repeat an earlier argument, it would
be useful to simulate the conditions that might be created by a MAI,
and see how much they might positively affect flows of FDI.
This is a subject to which we shall turn in the next few sections.
5.
Measuring the Impact of Transparent Regimes on FDI Flows
a.
The Model
As we have
argued above, the process by which governments can make their FDI regimes
non-transparent is quite varied. For the purpose of this paper, non-transparency
will be defined as government policies or structures that impede the
efficient flow of direct investment between countries by imposing implicit
costs and information asymmetries on the actors in the international
capital market. Thus, government policies that condone or even permit
corruption, that do not provide for an effective protection of property
rights, that are implemented by inefficient bureaucracies and
that are highly unstable will generate non-transparent regimes that
will retard the flows of investment. This lack of transparency
will impede the ability of foreign firms to participate in a nation’s
market.
In theory,
firms should be less likely to enter a non-transparent country because
of the increased risks, uncertainty and costs of doing business.
The analogous situation is that countries that maintain and promote
transparent policies and structures will attract more investment.
Since this hypothesis is about observable action, it should be possible
to quantitatively test for it. Therefore, a regression analysis
model is used to test this hypothesis.
The questions
that we want to answer in this paper are the following: "Does 'transparency'
matters as a factor influencing FDI decisions?" "If
so, how? Can we estimate the effects of better (higher) transparency
on FDI inflows?" We hypothesize that non-transparent
regimes inject uncertainty and information asymmetries into the international
capital markets. Under non-transparent conditions, investors will require,
ceteris paribus, a proportionally greater financial return to compensate
for their higher risks. Without the extra costs of non-transparent
regimes, the flow of FDI would be different. Pari passu,
a country's need for investment may be more acute than that of its
neighbor, but, due to its non-transparent investment regime, FDI
flow to the more transparent market. Once again, FDI are not necessarily
earning the best possible returns. It should follow, therefore, that
countries that improve the transparency of their policy regimes should
also see an increase in foreign investment in their countries.
If this
hypothesis is correct then analysis of investment flows should show
this. The econometric model presented in this paper is designed
to test this hypothesis. The model will be described in the following
section.
In order
to test our hypothesis, we need to develop a general model of foreign
investment behavior. In other words, we need a model of the market for
international capital investment. Since transparent policies are
expected to have a significant impact on the level of foreign investment,
the degree of transparency must be parameterized in the model.
We
shall hypothesize that foreign investment inflows depend on the degree
of transparency, the level of economic activity in the host country,
the level of interest rates, inflation and exchange rate changes
in the host country and on the level of openness of its trade regime.
To put it more simply,
(1)
FDI = f (T, Y, r, i, ER, TR, C),
where
T = transparency
Y = economic growth
r = interest rate
i = inflation
ER = exchange rate changes
TR = openness of trade regime
C = country
dummy
We expect
transparency, economic growth, exchange rate stability and
open trade regimes to be positively related to FDI. In contrast,
we expect both interest rates and inflation to be inversely related
to FDI.
The mathematical
expression of our model is
(2)
FDI/GDP = +
β1T + β2Y +
β3r + β4i +
β5ER + β6TR +
β7C + μ
Where
μ is a random term.
It is clear that the model is simplified. For example, we have not allowed for the impact of different technologies and their sophistication on investment choices. Nor have we specifically considered home-country factors such as legal treatment of corruption practices of multinational firms in foreign countries. We are aware that host country legal provisions for joint ventures and wholly-owned subsidiaries may also influence investment decisions of multinational firms.27 However, it is also evident that the corresponding extension of the model would most likely be counter-productive as the degrees of freedom would be reduced. Pari passu, we are confident that the impact of these factors is adequately treated in the model by the "country" and "trade openness" variables.
b. Methodology
Estimating
the above model can pose significant technical difficulties. There
are two hurdles that are especially commonplace in macroeconomic models
- endogeneity and omitted variable bias, both of which were encountered
in our estimations. This means, above all, that it may be difficult
to separate the impact of different exogenous variables in the model.
In real life many actions are occurring simultaneously. In addition,
it is often difficult to unambiguously identify the factors that
are causing the observed outcomes. In the case of our estimations,
for example, economic theory maintains that investment is a major factor
of GDP growth. Normally, as investment increases, GDP growth also
increases. Thus, investment causes GDP growth. At the same
time, economic theory also tells us that rapid growth of GDP can attract
investment – domestic and foreign. The faster economic growth,
ceteris paribus, the greater the investment needed to maintain
the growth at a sustainable rate. A high rate of growth of GDP signals
increased market opportunities that attract more firms, which generates
more investment. In this case, high GDP growth causes increased investment.
The relationship between GDP growth and investment is, therefore,
symbiotic and occurs simultaneously. To put it differently, it
is very difficult to determine causality. The statistical result
in the presence of endogeneity is a biased estimate and inconsistency.
As a result more care must be exercised in the development and estimation
of the model. The specific processes and techniques used to deal
with this problem are discussed below.
The second
problem is the likely existence of omitted, but relevant information.
Many factors come into play when a firm makes a decision. As a
result of the large and complex nature of economic processes, it is
almost impossible to fully account for or quantify all the factors.
The statistical result in the presence of omitted variables leads
to what is known as omitted variable bias. In practice, this
means that the impact of the factors not included in the model are
captured in part by the other factors in the model. The estimated
effects capture both the impact of the variable in question and the
variables not included in the model.
As noted
above, additional variables are needed to capture the economic conditions
of the country that could attract foreign investment in addition to
real GDP. The annual average of interest rates for each year is
included as a measure of the opportunity cost of capital. A variable
measuring the fluctuation of the national currency to the U.S. dollar
is included as a proxy for exchange rate stability. A country
with an unstable currency is likely to pose more risk and uncertainty
and thus be less attractive. The relationship between the
U.S. dollar and the national currency is used because real effective
exchange rate measures are not available for many of the countries in
the model. An indicator variable is included to indicate whether
a nation belongs to any treaty covering investment. This variable
is mostly an indicator for bilateral investment treaties with the US.
These agreements may indicate a general openness of a nation's investment
policy to foreign firms. A country that is a member of multi-
or bilateral investment treaties is considered to have a more open trade
regime. Furthermore, while all monetary variables are
in real terms, the actual inflation rate is included as a proxy for
perceptions of the financial soundness of the economy.
The last variable included is an indicator variable for each of the
nations in the sample. This is included to account for country
specific factors that would otherwise not be accounted for in the model.
Such a variable will capture effects that are not attributed to the
other variables and are specific to that particular observation.
The level of
investment in each country is normalized by dividing FDI by the
country's GDP. This allows us adjust the level of investment
for the size of the country's economy. This transformation is
useful for two reasons. First, it allows for more direct comparison
between countries. Simply comparing the levels of investment in
the US versus that of, for example, Botswana is not very useful
because of the extreme difference in the size of the economies.
Secondly, the size of a country's GDP is likely to be relevant for the
amount of FDI the country receives. Simply put, a larger
economy has more opportunities for investment. If GDP size were
to be included as an independent variable, it would likely suffer from
the same statistical problems as GDP growth. Thus, this transformation
allows to take the market size into account in the model, but
avoids the problem of endogeneity.
As previously
mentioned, the possible existence of endogeneity and its attendant bias
and inconsistency pose some difficulties. As a result two different
forms of statistical models were employed. The standard regression
model employed is an OLS regression model. This form imposes the
fewest structures on the data and, barring the existence of endogeneity,
returns the most accurate, unbiased estimates. However, this model
form cannot account for the potential presence of endogeneity.
Therefore, it is necessary to also utilize a second statistical model
– the Two-stage - least squares (2SLS) regression model – that can
account for the presence of endogeneity. The effectiveness of
such model in removing the bias depends on the structure of the model.
This statistical model attempts to eliminate the bias by finding a proxy
for the variable causing the endogeneity. The key to the selection
of such a proxy, or instrumental variable, is that it must be highly
correlated with the variable causing the endogeneity, but be unaffected
by the other variable. The selection of instrumental variables
is troublesome because these conditions are difficult to meet.
We have, therefore, decided that, prior to investing the effort into
finding instrumental variables, we shall first test for the presence
of endogeneity.
For testing
for endogeneity in the model we have utilized the standard Hauseman
Specification test. The empirical results of this test on the variables
in the model are included in Appendix. The test results indicate
that GDP growth is an endogenous variable and instrumenting was, therefore,
necessary. We have identified three candidates for instruments
- rate of growth in gross capital formation, rate of growth in
employment and rate of growth in population. Three different specifications
of the 2SLS model were, therefore, estimated, each using one of the
potential instruments.
Additional
discussion of transparency is warranted. The concept of transparency
is necessarily subjective, as it relates to perceptions of the investment
climate in the host country. The same is true for different measures
of transparency, such as the transparency index we have used in our
study or the Transparency International's Index of corruption.
As a result of the subjectivity involved and the fact that different
actors may weigh the individual components of transparency differently,
attempts to instrument the index using specified, known economic variables
would not likely be successful. There are no known economic variables
that would be robust and, at the same time, would not be correlated.
Similarly, with other variables in the model,
attempts to instrument transparency using social variables, such as
the ethnic composition of the population or cultural history will most
likely prove to be spurious and have a limited usefulness outside
a limited group of specifically targeted studies. For these
reasons, they would also not be useful in comparisons between
Western, developing and transition economies.
Furthermore,
we present the individual components of the transparency index in an
aggregated form for a specific theoretical reason. We have strong
reasons to believe that investment decisions are made with respect to
the overall state of transparency within a country, rather than with
regard to its individual components. As noted above, the
degree of transparency is a subjective measure. Individual actors
are liable to give different weight to different components of the index.
It is equally possible that investors do not perceive
the individual components at all, but rather recognize relative differences
in the overall business climate, even though these are derived
from the individual components of the index. Furthermore, by its
very nature, the lack of transparency cannot be accurately assessed
a priori. This means that the full costs of non-transparent
policies can only be assessed after the costs have been incurred.
By taking investment decisions with respect to individual components
of transparency, the margin of error from business decisions is increased.
To put it differently, the margin of error associated with a composite
index is most likely smaller since errors associated with specific perceptions
and decisions may offset each other. Therefore, we strongly believe
that a separate treatment of the individual components of the transparency
index in our model fails to conform to our hypothesis of how investors
view and manage their risk and, in terms of econometrics, our approach
seems more sensible.28
c.
Data
Foreign
direct investment is defined in this paper as investment in capital
stock or assets by a company abroad. This should be distinguished
from portfolio investment which is an investment into a financial asset
and typically with a shorter-term horizon. There are four primary methods
of foreign direct investment that can be identified. The first
is when a company obtains sufficient common stock in a foreign company
to assume voting control. Second is when a company acquires
or constructs plants and equipment in a foreign country.
Third is when a company shifts funds abroad to finance an expansion
of a foreign subsidiary. Fourth is when earnings of a company’s
foreign subsidiary are reinvested in the foreign subsidiary instead
of being returned to the parent company.29
Transparency
will be measured with the help of rankings of countries in terms of
transparency. The rankings are taken from the International
Country Risk Guide published monthly by Political Risk Services,
(PRS). Analysts at PRS develop rankings for 162 countries on a
monthly basis. PRS rankings for the level of corruption, law and
order, bureaucratic quality, contract viability and the risk of government
expropriation of private assets are combined to form one transparency
index.30 The higher a country's rank
the more transparent their policies and institutions. The
coefficient on the transparency index will indicate the degree to which
transparency impacts the flow of foreign investment into that country.31
The sample of data used in this study and the countries' rankings
are summarized in Table 1.
TABLE 1
: The Sample: Country Rankings According To Their Transparency
Country | Average Rank | Years Included in Sample | ||||
New Zealand | 38 | 1992-1995 | ||||
Denmark | 38 | 1992-1995 | ||||
France | 38 | 1992-1995 | ||||
Netherlands | 38 | 1992-1994 | ||||
Finland | 37.5 | 1992-1995 | ||||
Germany | 37.5 | 1992-1995 | ||||
Norway | 37.5 | 1992-1995 | ||||
Canada | 37 | 1992-1995 | ||||
Japan | 37 | 1992-1995 | ||||
Austria | 37 | 1992-1995 | ||||
US | 36 | 1992-1995 | ||||
UK | 36 | 1992-1995 | ||||
Korea | 34.5 | 1992-1995 | ||||
Spain | 33.5 | 1992-1995 | ||||
Israel | 33.5 | 1992-1995 | ||||
Jordan | 33.5 | 1992-1995 | ||||
Czech Republic | 32.5 | 1994-1995 | ||||
Italy | 32 | 1992-1994 | ||||
S. Africa | 31 | 1992-1995 | ||||
Singapore | 30.5 | 1992-1995 | ||||
Egypt | 29 | 1992-1995 | ||||
Costa Rica | 28.5 | 1992-1995 | ||||
Botswana | 28 | 1992-1995 | ||||
Morocco | 28 | 1992-1995 | ||||
Chile | 28 | 1992-1995 | ||||
Indonesia | 27.5 | 1992-1995 | ||||
Argentina | 27.5 | 1992-1995 | ||||
Syria | 26.5 | 1992-1994 | ||||
India | 26 | 1992-1993 | ||||
Paraguay | 26 | 1992-1995 | ||||
Venezuela | 26 | 1992-1995 | ||||
Columbia | 25.5 | 1992-1995 | ||||
Ecuador | 25 | 1992-1995 | ||||
Nicaragua | 25 | 1992-1995 | ||||
Uruguay | 25 | 1992-1995 | ||||
Dominican Republic | 24.5 | 1992-1995 | ||||
Philippines | 23 | 1992-1995 | ||||
Bolivia | 23 | 1992-1995 | ||||
Pakistan | 21 | 1992-1995 | ||||
Nigeria | 21 | 1992-1994 | ||||
Panama | 20.5 | 1992-1995 | ||||
El Salvador | 20 | 1992-1994 | ||||
Honduras | 20 | 1992-1995 | ||||
Zambia | 19 | 1992-1993 | ||||
Guatemala | 19 | 1992-1995 | ||||
Bangladesh | 17.5 | 1992, 1994-1995 | ||||
Sierra Leone | 12 | 1992, 1994-1995 | ||||
Thailand | 10 | 1992-1994 | ||||
Malaysia | 8.5 | 1992-1995 | ||||
Source: See the text. |
The figures
in the table rank countries according the level of transparency
of their policies and institutions. The country with the highest rank
is regarded as the most transparent and vice versa for
countries with the lowest rank. The sample used in our estimations
covered 52 countries – a smaller sample than the one used by PRS for
reasons already explained. In our sample, the country with the highest
rank ( the most transparent country) are New Zealand, Denmark,
France and the Netherlands and the country with the lowest rank ( the
least transparent country) is Malaysia.
For the estimation
of the model we use data compiled from several sources. In addition
to the transparency index described above, we use data on interest rates,
GDP, inflation, total investment, population, capital formation
and employment levels. All of these variables taken from the IMF publication
International Financial Statistics, (IFS). Data on foreign
investment is taken from both IFS and the United Nation's (UNCTAD)
World Investment Report. As noted, data on fifty-two countries
over the years 1991-1995 are included in the data set.
The sample
includes data on countries' variables on which the observations covers
a relatively short period of time – two to four years. This
is not an ideal time coverage to capture fixed effects of these variables.
The reason is that the data may have been subject to short-term fluctuations.
It would certainly have been preferable for us to use longer time series
but, unfortunately, we were seriously constrained by data availability
and resources. Nevertheless, it is our belief that this limitation
will not fundamentally distort our estimations – unless a critical
mass of our sample were to be indeed affected by economic instability
during the examined period, which we do not believe was the case.
d.
Empirical Estimates
We have made the estimation
of our model using both ordinary least square method (OLS) and two-stage-least-squares
method (TSLS). The main difference between both sets of simulations
is the inclusion of instrumental variables in the TSLS method.
The results of our estimations are summarized in Table 2. Estimating
the model using a standard OLS approach generates very encouraging results.
The transparency index variable returns a coefficient of .0106.
The positive sign on the coefficient indicates that as a country’s
transparency ranking increases, they should experience increases in
foreign investment.
However, as
previously noted, the OLS estimates are likely to be biased as a result
of endogeneity in the model. This was also confirmed by standard
test statistics which showed, inter alia, high standard errors.
The estimates of two of the coefficients had wrong signs in comparison
to our expectations. It was for these reasons that we have re-estimated
the model using the TSLS method. The results of the re-estimation
are very encouraging. All three variants of the model brought
dramatic improvements to the quality of the estimates. The coefficients
have the correct signs,32 the standard errors (and
t-values) are acceptable in at least one of the three variants, and
the correlation coefficients are also reasonably high. Even though
we have not attempted a formal discrimination among the three different
sets of TSLS estimates, it appears that the best fitting model is the
one using "population" as the instrumental variable. An explanation
for this choice is provided further below.
Table 2 TSLS regression with robust standard errors
Change in Population
as Instrumental Variable
FDI/GDP | Coefficient | Standard
Error |
t-value | P>|t| | [95% Conf. Interval] | |
GDP growth | .03486 | .02325 | 1.499 | 0.138 | -0.1141 | .0811 |
Transparency | .02435 | .01047 | 2.324 | 0.023 | .0035 | .0452 |
Inflation | .00124 | .00239 | 0.518 | 0.606 | -.0035 | .0060 |
Interest rate | -.00003 | .00006 | -0.648 | 0.519 | -.0002 | .0001 |
Exchange rate | .38156 | .32033 | 1.191 | 0.237 | -.2559 | 1.0191 |
BIT | .06085 | .12347 | 0.493 | 0.623 | -.1848 | .3065 |
Number of observations = 135
R-squared
= .5816
Table 3
compares the results of the OLS model with the results of the three
specifications of the TSLS model. The cells present the
estimated marginal impact of a one unit change in the noted variable
in the FDI/GDP ratio. A positive value indicates an increasing
level of FDI while holding total GDP constant, resulting from an increase
of the transparency variables.
Table 3
Simulation Results: Estimated Value of FDI/GDP
OLS Model | Instrumented
Model
Gross Capital Formation |
Instrumented
Model
Change in Employment |
Instrumented
Model
Change in Population |
|
Effect of Transparency Rank | .0106 | .0088 | .00353 | .0244 |
Effect of GDP growth rate | .00163 | -.00460 | .00198 | .0349 |
The most
interesting result is that the estimate of the marginal impact of
the transparency rank is positive. That is, as countries increase
the degree of transparency in their economy, their attractiveness to
foreign investment increases. The fact that different specifications
all return positive estimates of the marginal impact of transparency,
while reporting varying impacts of GDP growth, indicates a particularly
robust result.
In order to
examine the predictive power of the model several examples are presented
below. The tables below (Tables 4 and 5 )
provide examples of the predictive power of the models. Table 4
lists the average percent difference between the actual FDI/GDP ratio
and the ratio predicted by each of the models. Table 5
lists the actual ratio of FDI/GDP of several countries in the sample
and the ratio of FDI/GDP each model predicted that the country should
have received. The closer the predicted levels of FDI/GDP ratio
to actual, the more accurate the model.
Table 4
Model Specifications and Estimated Errors
Model Specification | Average Difference Between Actual and Predicted FDI/GDP Ratios |
OLS | -3.3 percent |
Instrumented Using Change in Capital Formation | 3.9 percent |
Instrumented Using Change in Employment Level | -0.2 percent |
Instrumented Using Change in Population | 20.1 percent |
Comparing the
predicted results of the model versus the actual shows that, while not
perfect, the different specifications of the model can be quite effective
in predicting the level of FDI a country is likely to receive.
Because of the statistical flaws discussed with respect to the OLS model,
it is not surprising that it is the least effective method in predicting
the correct outcome. One reason why the instrumental variable
technique using the change in population is likely to be more successful
is the larger number of observations. For several nations
accurate data on changes in gross capital formation and especially
on employment was not available, thereby reducing the number of
observations in the sample. This will also reduce the predictive
power of those models. Because the change in population is the most
effective instrument in predicting proper results it will be
the model used for discussing the substantive significance of improvements
in transparency.33
Given that
the model is fairly accurate in predicting outcomes, the logical
question is the extent to which transparency affects FDI.
The coefficients associated with the transparency variable report
the marginal impact of improving a country’s transparency ranking
by one point on the FDI. For the given sample, the average increase
in the FDI/GDP ratio a country could expect from a one-point increase
in its transparency ranking is approximately 40 percent. However, the
average percent increase is not a particularly good measure as evidenced
by the wide variations in results. This can be seen in the following
Table 5 which shows the impact of changes in the
transparency ranking for several countries in the model. It shows
the percentage increase a country could expect from a one point and
three point increase in their transparency ranking, respectively.
For some nations the three point increase puts their transparency ranking
higher than the upper limit. The out of sample designation denotes
these countries.
To reiterate,
the above Table 5 reveals a wide variation in the impact
of increasing transparency. This is in part due to the initial
level of foreign participation in the economy. Moreover, the
variation may also be due to the country's ranking relative to the
maximum possible value, two issues which are discussed in some
detail in the following section.
Table 5
Estimated Impact of Higher Transparency on FDI/GDP Ratios.
Country | Average Transparency Rank | Average %
Change in FDI/GDP Ratio,
1 point increase in TI Rank |
Average %
Change in FDI/GDP Ratio,
3 point increase in TI Rank |
Canada | 37 | 142 | Out of Sample |
Spain | 34 | 212 | 253 |
United Kingdom | 36 | 149 | Out of Sample |
Costa Rica | 28.5 | 173 | 186 |
Philippines | 23 | 566 | 619 |
Colombia | 25.5 | 262 | 284 |
Egypt | 29 | 315 | 365 |
Israel | 33.5 | 187 | 246 |
Thailand | 10 | 209 | 258 |
Indonesia | 29 | 263 | 295 |
Rep. of Korea | 34.5 | 222 | 448 |
Malaysia | 9 | 232 | 242 |
Pakistan | 22 | 620 | 690 |
Czech Republic | 28 | 242 | 254 |
Chile | 28 | 679 | 700 |
Ecuador | 25 | 277 | 292 |
Bolivia | 23 | 421 | 452 |
Guatemala | 20 | 648 | 711 |
Singapore | 30.5 | 221 | 230 |
Venezuela | 26 | 214 | 240 |
Note:
TI = transparency index.
While measuring
changes in a country's FDI/GDP ratio may aid cross-country comparisons,
the actual economic impact are not particularly clear. Therefore, Table
6 below presents the estimates of the
impact of improvements in transparency on actual levels of FDI for a
sample of countries. As the table demonstrates, the impact
of improved transparency on total FDI inflows could be quite dramatic.
Our simulation shows that the biggest increase would take place in Italy,
the Republic of Korea, and El Salvador
– not an unlikely scenario. Nevertheless, how useful these simulations
are will further depend on the functional type of relationship between
transparency and FDI inflows to which we shall now turn.
Table 6 A Simulation Exercise: Changes in FDI From a 1 Point Increase in the Transparency Rank.
(millions US$)
Country | Employment Instrumental Variable | ||
Observed Level | Predicted Level | Percent Change | |
of FDI | of FDI | in FDI | |
Italy | $3,206.10 | $6,447.00 | 101 |
Botswana | -$53.78 | -$42.70 | 21 |
Argentina | $1,812.15 | $2,729.60 | 51 |
Malaysia | $4,218.68 | $4,431.63 | 5 |
Pakistan | $389.70 | $514.83 | 32 |
Egypt | $629.55 | $741.45 | 18 |
Spain | $8,495.69 | $10,054.20 | 18 |
Morocco | $378.08 | $467.61 | 24 |
Sierra Leone | -$1.41 | -$0.82 | 42 |
Nigeria | $916.60 | $983.46 | 7 |
Zambia | $46.64 | $48.46 | 4 |
Indonesia | $3,260.56 | $3,663.96 | 12 |
Korea, Rep. of | $1,097.56 | $2,140.72 | 95 |
Czech Rep. | $1,158.91 | $1,219.38 | 5 |
Chile | $1,271.26 | $1,364.66 | 7 |
Ecuador | $335.21 | $352.89 | 5 |
El Salvador | $21.25 | $39.92 | 88 |
Guatemala | $85.71 | $110.80 | 29 |
Peru | $1,326.89 | $1,326.90 | 0 |
Venezuela | $897.71 | $986.49 | 10 |
e.
Further Qualifications
Our estimations
of the effects of improved transparency on FDI inflows in host countries
are subject to further qualifications. The estimations are , of course,
based on the assumption that the relationship between transparency and
FDI inflows can be represented by a continuous function with constant
properties. However, it is likely that the effects of improving
transparency are not constant. In fact, it is reasonable to assume
that countries with particularly poor transparency ratings will receive
only marginal increases in investment after initial improvements in
transparency. This may occur for two reasons. First,
when a nation has a particularly non-transparent policy and institutional
regime, small increases in their ranking would not substantially increase
their overall transparency. It would be the equivalent of lighting
a single candle in a pitch-black room - more can be seen, but
not enough to be truly helpful. Secondly, a nation would likely
have to maintain this improvement for a period of time to be taken seriously
by economic actors. Due to their history of non-transparency,
countries must maintain these improvements for a sufficient length
of time to make their commitments credible.
An analogous
situation would exist in countries with high transparency rankings.
In such an economy the marginal return from the increase in ranking
is not substantive. Using a parallel example, again, the equivalent
of switching from a 100 watt light bulb to an 120 watt bulb in a large
room will not be noticeable. In addition, a nation's policies
and commitments must be seen by investors as credible as noted above.
Once again, this means that the policies have to be pursued for some
time before they will indeed be seen by investors as truly credible.
A new signal of transparency will not necessarily add to this commitment
immediately.
Given all these
considerations, the relationship between transparency and FDI
inflows is likely to be non-linear. The following graph 1 shows how
the shift to higher levels of transparency may impact a country’s
attractiveness to FDI.
Graph 1
If these two
situations hold then there should be some level(s) of transparency where
increases in a country’s ranking serve as an effective signal of their
commitment to transparency and causes substantive decreases in the risk
and uncertainty faced by economic actors. To empirically test this hypothesis
an additional model was estimated. This model includes two additional
variables for the Transparency Index. The model adds a squared
and cubed form of the original Transparency Index variable and estimated
using the change in population as the instrumental variable. The
signs on the coefficients of the three forms of the Transparency Index
indicate the form of the slope when plotted against the ratio of FDI/GDP.
The results are summarized in Table 7.
Table 7
Non-linear Re-estimations
Variable | Estimate |
Transparency Index | -.0929 |
Transparency Index Squared | .00378 |
Transparency Index Cubed | -.0000391 |
The statistical
estimates of this model are very close to those expected by the hypothesis.
If the hypothesis is correct the coefficient on the linear term would
be positive, the coefficient on the squared term would be positive and
the coefficient on the cubed term would be negative. The negative
coefficient on the linear term is easily explained however. It
is likely a function of the sample. The countries in the sample
are more heavily distributed along the middle and upper ranges of the
transparency index. This lack of observations prevents the model
from estimating a proper fit for the linear term.
The table roughly
shows that some increases in transparency cause greater investment then
others. Specifically, this table would indicate that increases
in rankings into the high teens and low twenties cause especially high
increases in investment.
6. Policy
Implications
Our empirical
tests show that countries' attractiveness to foreign investors is quite
closely linked to the degree of transparency of their policies. The
(relatively) more transparent are the country's policies and institutions,
the more attractive is the country to foreign investors. Thus,
if we accept the premise that more FDI is good for countries' growth
and development, the first,
self - evident policy recommendation follows from this premise -
policy makers should make sure that their policies are transparent to
potential foreign investors.
Our simulations
have also shown that not only the relationship between transparency
and FDI inflows is positive but this relationship is in fact quite strong.
An improvement in a country's ranking by only a few points will
significantly improve the country's attractiveness to foreign
investors and should lead to a correspondingly large marginal inflows
of FDI. Thus, our second policy recommendation is that
policy makers should pay a great deal of attention to transparency
as a feature of their policies. They should concentrate on this aspect
of policy – making perhaps even more than attempting to "fine-tune"
other policies to attract foreign investment - in particular those
concerning financial incentives.
Investment
decisions are based, inter alia, on expectations and human
psychology. This means that signals generated by economic policies may
take time to be absorbed by investors who will have to be convinced
that the policies will not be reversed. In other words,
the policies must be credible which leads us to the third
policy recommendation - policy makers must accept that some
degree of patience is an integral part of policy-making even though
election imperatives and other political goals may dictate otherwise.
We could not
distinguish in our simulations among the different elements of non-transparent
FDI regimes that we have identified above. Our measure of non-transparency
is an aggregate one. Hence, no specific and detailed recommendations
are possible with respect to these different types of non-transparency
apart from the general comments made earlier in the paper. Nevertheless,
our findings are consistent with those who argue that least competitive
countries are also most corrupt.34 This would, therefore, suggest that
corruption and bribery should be particularly targeted by policy makers
whenever they wish to make their investment regimes more transparent.
A final comment can be made about the extent to which countries should undertake international obligations in order to improve their transparency. As we have suggested above, it is clear each country's policy-making must start with more transparent domestic legislation and policies and a strong law enforcement mechanisms. But this raises the question whether approaches based on national solutions are sufficient. We strongly believe that this is not the case. For example, domestic legislation on corruption is unlikely to replace international commitments. Moreover, national solutions are certainly not enough if the same solutions are not adopted by all countries! Thus, our fourth and final policy recommendation is that countries should seek and support international approaches to improve transparency of their policies as much as possible. The only remaining question is whether these approaches should be bilateral, regional or multilateral
What kind of
international solutions? Given the affiliation of one of the present
authors, it will not be surprising to the reader that we strongly favor
a multilateral approach.35
7.
Post Scriptum.
We are painfully
aware that the concept of transparency is quite elusive
and, therefore, very difficult to measure. This also means that simulations
of the relationship between transparency and FDI flows are subject to
ambiguity of data and errors of measurements, quite apart from
all the econometric difficulties that we have encountered and discussed
in the text. Ideally, we should have been dealing with transparency
per se since it is the actual level of transparency that really
matters in investment decisions. Unfortunately, there is no way of unambiguously
measuring this phenomenon and we had to rely on a relative
measurement – international ranking. Moreover, we have relied on the
data base provided by one source – PRS – that has been widely
used in the literature and by the business community.
We have made no effort to compare either the methodologies or the actual
ranking of countries in our sample across different sources. To the
extent that there are differences, we have, therefore, made no attempt
to reconcile them.
Since the estimations have been done with the help of different techniques we have obtained different estimates. Some of the estimates appear better than others but we have not made the additional step of discriminating among the results. This could obviously be another step that we could take in order to improve econometric tests. We feel, however, that the benefits to be obtained from these improvements would probably not justify the costs. These shortcomings notwithstanding, we are very encouraged by our econometric results. The results are robust and statistically significant. They drive home the main point that transparency matters for foreign investors, and that it matters a great deal.
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1 Taken from his speech at the 24the Annual Conference of the International Organization of Securities Commission in Lisbon, on May 25, 1999. Also reported in IMF Survey, June 7, 1999.
2All data come from Drake (1998)
3 Ibid.
4 Quoted in Kamata (1997§).
5 Ibid.
6 This topic has been discussed in a number of publications. For a more recent piece see, for example, Weimer (1997).
7 Again, a wide variety of literature exists on the impact of property rights protections on different aspects of economic development. See, for example, North (1987).
8 See, for example, Weimer and Vining (1992).
9 Developing countries are likely to be tempted to avoid international commitments on intellectual property rights. They often see them as a barrier to the access to modern technology and thus to economic development. For more discussion see, for example, Rapp and Rozek (1990).
10 The Law and Order issues can become particularly troublesome for companies. Primarily this represents the suppression of laws for political reasons or the ability of the government to overturn court decisions that it does not agree with. This poses severe constraints on the credibility of contract law and property right protections.
11 E. Luce in Financial Times, June 7, 1999
12 In all fairness, the Fund had a very sensible explanation at the time – that provision of sensitive information could heavily influence the markets.
13 See WTO, G/TBT/W/113, 15 June 1999.
14 See Financial Times, June 15, 1999, p.5
15 Ibid.
16 Countries commonly require licenses for investment, limit the level or degree of foreign ownership in capital assets or otherwise impose restrictions on the entry and activity of foreign actors in the markets. Government bureaucracy controls these types of restrictions and regulations. These controls provide easy avenues for corruption. This can take the form of bribes for import or export licenses, exchange rate controls or loans. This type of corruption reduces efficiency.
17 These figures come from Kaufmann, Pradhan and Ryterman (1999). The estimates were obtained from detailed survey of firms in the respective countries.
18 See, for example, Hoekman and Saggi (1999) for a review of the literature.
19 As we shall argue in the following section, there is a high correlation between a country's exposure to international trade and the size and the quality of government services. Strong empirical evidence about the positive contribution of liberalization on FDI inflows can be found in Selowsky and Martin (1997).
20 For more discussion see Drabek (1998).
21 The resistance mainly comes from developing countries, which fear that they are not yet ready to face competition of multinational companies from developed countries. Nevertheless, the current reluctance is also shared – albeit with less vigor – by some developed countries (e.g. USA). The position is also defended by some researchers who call for a consolidation of the existing Uruguay Round agreements before tackling a MAI. See, for example, Hoekman and Saggi (1999).
22 See reference in Introduction above.
23 The same points are also made in OECD (1997a) and (1998) which provides a discussion of these issues.
24 For more details, see WTO (1996), pp. 69 – 73.
25 This agreement is already effectively used by members for the protection of their companies. For example, the United States government has recently requested consultations with the Government of India about the latter's measures affecting trade and investment in the automobile sector. The measures require manufacturing firms to achieve a certain local content and a neutralization of foreign exchange by balancing value of certain imports to a value based on the previous year's exports. These measure relate to Article 8 of TRIMs. Similar issue have been raised with Indonesia. Following the ruling of the Dispute settlement Board, the Indonesian government has been already taking measure to repeal the original program.
26 See Barshevsky on APEC, Global Trade Liberalization; in USIS Geneva, Daily Bulletin, 1 July 1999.
27 See, for example, Smarzynska and Shong-Jin Wei (2001).
28 However, in pursuing our due diligence in the investigation of the accuracy of the model, a specification with the components included on an individual basis was estimated. This specification resulted in significant reductions in statistical significance of the transparency variables. Further analysis showed that the individual components had high degrees of correlation with each other, resulting in inefficient estimates.
29 These and other related methodological issues are discussed in Carbaugh ( 1995 ).
30 There are other data sources comparing transparency across countries. For example, Merchant International Group regularly prepares indices of the so-called " gray – area" risks brought about by political and religious fanaticism. Another well known source is Transparency International Index. The Index refers to comparisons of corruption, and it is therefore narrower than the comparable PRS indices, which are more suitable and appropriate for our purposes.
31 The veracity of the PRS rankings can be inferred by the fact that this information is highly sought after. Private firms pay thousands dollars a year to acquire this data for use in determining where they will invest.
32 The only exception is the estimated "inflation variable", which is estimated with a positive sign. However, the confidence interval is sufficiently wide to allow a negative range, as predicted by the theory.
33 The choice of instrumental variables used to replace GDP growth is debatable. Gross capital formation and change in employment will not be suitable if related to FDI and GDP. This is quite a likely condition but over a long-run and with substantial time lags. Population variable is probably less related to FDI (change) but may not be the best instrument for GDP growth. While we chose the "population"-based model as the "best", it is important to note that the other two simulations – with gross capital formation and employment as the instruments – generated results which were as encouraging as those based on "population" as the instrument.
34 The studies are quoted, for example, in Krastev (1999).
35 For more discussion and justification of this point see Drabek (1998).
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